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The Real Lesson From the Great Depression: Fiscal Policy Works!

Posted By Guest Author On September 6, 2010 @ 1:00 pm In Economy,Taxes and Policy | Comments Disabled

Marshall Auerback is a Denver, Colorado-based global portfolio strategist for RAB Capital.

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If the US government had a dollar every time someone proclaimed to learn the lessons of the Great Depression, we probably wouldn’t have a budget deficit. Usually, these debates turn on the question of fiscal policy and whether in fact, FDR’s New Deal had a discernable role in generating recovery. “Fiscal austerians [1]” have done much to dismiss the economic achievements of the New Deal, some even suggesting that FDR’s fiscal policies worsened the crisis.

For a brief period during 2008, the views of neo-liberals like Alan Greenspan and Robert Rubin were shunted aside. But the FDR revisionists, who disapprove of fiscal policy measures of any kind, have come back. Now they’re brandishing the old arguments that “excessive” government spending risks “crowding out” private spending, making it impossible for the US government to deal with the recession (because it has run out of money) and hindering the capacity of the private sector to recover because of too much government interference in the “free market”. These complaints are usually accompanied by a wave of rhetoric condemning the “business un-friendly” policies of the current Administration, along with dire warnings of a “national solvency” crisis. After all, fiscal austerians are nothing, if not fully predictable.

Was the 1937 Relapse Caused by Increased Taxes and Unions?

In that context, we have to give some credit to Professors Thomas Cooley and Lee Ohanian, who have taken a more novel approach in their critique of the New Deal. In some respects, they actually validate the case for fiscal policy expansion (although the two authors might not see it that way). Cooley and Ohanian argue [2] that:

The economy did not tank in 1937 because government spending declined. Increases in tax rates, particularly capital income tax rates, and the expansion of unions, were most likely responsible. Unfortunately, these same factors pose a similar threat today.

The OMB numbers suggest that spending actually DID decline in 1937 and 1938 (see here [3]) and, contrary to the assertions of Cooley and Ohanian, that decline had a very deleterious impact on economic activity and employment. I will address the tax issue presently, but let’s first deal with the “excessive unionization” canard. An objective observer looking at the US in the 21st century would hardly conclude that unions have any real power in the American economy today, any more that we have a “socialist” government dedicated to the promotion of a vast left wing agenda which enhanced union power. Obama has not addressed Labor Law reform and wages haven’t risen in a generation; in fact, last year they fell.

True, the President occasionally does display a social democratic rhetoric, but so far, redistributive policies have primarily benefited financial institutions. Social security benefits are under threat via a new “bipartisan commission” on long term deficits, public health care insurance proposals were eviscerated in the “health care reform” bill, and trade unions outside the public sector have withered over the past 30 years. Cost of living adjustment clauses have largely disappeared since the early ’80s (although some government benefits like social security retain them), average hourly earnings are virtually flat, and I would not be surprised to see wage deflation before the unemployment rate peaks this time around. US households are paying down debt on a net basis — even credit card debt — and creditors remain reluctant to make new loans. So the odds of a wage/price spiral taking root as a consequence of excessive union power look decidedly low – in fact, close to zero.

On the other question of taxes, I actually have some degree of sympathy with the arguments of Cooley and Ohanian, but largely because functionally, a tax increase works as a countercyclical policy which mitigates the impact of fiscal policy expansion.

Let’s go back to basics. Under a fiat currency regime, such as we have in the US, when the Federal government spends, it electronically credits banks accounts. Taxation works exactly in reverse. Private bank accounts are debited (and private reserves fall) and the government accounts are credited and their reserves rise. All this is accomplished by accounting entries only, but the main point is that spending creates new net financial assets and taxation drains them.

So in one sense, Cooley and Ohanian are right. Tax hikes do cut aggregate demand, much as government spending cuts do. In economic terms, both serve to depress economic activity. We agree with the authors: tax rises at this juncture are a dumb idea. They won’t serve to “reduce” the deficit, because the resultant impact on private sector activity is likely to diminish it and thereby increase the gap between government expenditures and revenues as the economy slows down.

The broader issue of government spending versus tax cuts is a political/distributional argument, and economists (and others) can legitimately argue about the respective multiplier effects of one versus the other. But at least this kind of discussion shifts the debate in the right direction -toward increasing economic activity and, hence, job growth and away from wrong-headed discussions of fiscal austerity and deficit reduction as a primary policy goal of government. FDR ran into trouble only when he moved away from fiscal expansion toward austerity in 1937.

At the outset of the Great Depression, economic output collapsed, and unemployment rose to 25 per cent. Influenced by his “liquidationist” Treasury Secretary, Andrew Mellon, then President Hoover made comparatively minimal attempts to deploy government fiscal policy to stimulate aggregate demand. Further, the Federal Reserve actually sold bonds to push up interest rates in a mindless effort to stem the gold outflows that we occurring as the rest of the world lost confidence in the US economy. So much for the halcyon days of the gold standard!

FDR’s Employment and Wage Strategy Worked

This all changed under FDR. The key to evaluating Roosevelt’s performance in combating the Depression is the statistical treatment of many millions of unemployed engaged in his massive workfare programs. The government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown.

It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock. So much for the notion that government jobs are not “real jobs”, as we hear persistently from critics of the New Deal!

The reasons for the discrepancies in the unemployment data that have historically arisen out of the New Deal are that the current sampling method of estimation for unemployment by the BLS was not developed until 1940 (for more detail see here). If these workfare Americans are considered to be unemployed, the Roosevelt administration reduced unemployment from 25 per cent in 1933 to 9.6% per cent in 1936, up to 13 per cent in 1938 (due largely to a reversal of the fiscal activism which had characterized FDR’s first term in office), back to less than 1 per cent by the time the U.S. was plunged into the Second World War at the end of 1941.
In fact, once the Great Depression hit bottom in early 1933, the US economy embarked on four years of expansion that constituted the biggest cyclical boom in U.S. economic history. For four years, real GDP grew at a 12% rate and nominal GDP grew at a 14% rate. There was another shorter and shallower depression in 1937 largely caused by renewed fiscal tightening (and higher Federal Reserve margin requirements).

This economic relapse has led to the misconception that the central bank was pushing on a string throughout all of the 1930s, until the giant fiscal stimulus of the wartime effort finally brought the economy out of depression. That’s factually incorrect. Most accounts of the Great Depression understate the effect of the New Deal job creation measures, because they don’t show how much of the decline in official employment was attributable to the multiplier effect of spending on direct job creation. Also, the “work relief” category does not include employment on public works funded by the Public Works Administration (PWA) nor the multiplier effect of PWA spending. The figures tell the story indirectly, however, in the path official unemployment followed — steeply declining in periods when work relief spending was high and either declining more slowly or increasing in periods when work relief spending was cut back. In fact, by the end of 1934, more than 20 million Americans (one out of six!) were receiving jobs or public assistance of one form or another from the “Welfare State”.

Yes, 9.6% unemployment at the end of 1936 was still a big number. But it’s hard to imagine the Democrats being in political peril for the midterms, or witnessing the current abysmal state of Obama’s popularity ratings, if today’s Administration could reduce unemployment by two-thirds in one term in office, as FDR did under any honest measure of unemployment. Suffice to say, unemployment reduction was the singular focus of the Roosevelt Administration; by contrast, today we have “the new normal”, in effect, a faux intellectual argument to justify why we can’t generate higher job growth. It’s a testament to political failure.

In reference to the criticism of FDR’s “high wage” policy by Cooley and Ohanian, it is worth noting that the wage “inflation” which they decry was in reality a product of a deflationary environment in which the general price level fell faster than the money wage level. During the outset of the Great Depression, output generation collapsed in the face of the US federal government’s fiscal inaction and central bank interest rate hikes. This had the strange result of generating a counter-cyclical real wage increase, which in fact was nothing more than a product of depressed nature of the economy, in which overall prices were deflating prices faster than wages (for more information see here [4]).

Overlaying the wage data with the true reduction in unemployment between 1933 to the end of 1936, makes it difficult to mount an empirical case that FDR wage improvements during the Great Depression were damaging to overall economic growth and increasing employment. Even if some sectors were disadvantaged (and that isn’t proven by Cooley and Ohanian) the evidence actually suggests that the rises in real wages were associated with rising overall employment.

Relapse Caused by Austerity Measures

What about the relapse in 1937/38? By 1936 many economists and financial experts (notably FDR’s Treasury Secretary, Henry Morgenthau) feared the country would go bankrupt if the government kept deficit-spending (sound familiar?). And after all, they argued, the government deficits had “pump-primed” the economy. The private sector could now take off on its own and get back to close to the full employment level of 1928-early 1929.

Consequently, Roosevelt ran (in 1936) on a platform that he would try to reduce, if not eliminate, the deficit. He won the election by a landslide — understandably, as the U.S. was out of depression by 1937. True to his campaign promise, government spending was cut significantly in 1937 and 1938, and taxes were raised to “fund” the new Social Security program. By 1938 Roosevelt submitted a budget in which the deficit was virtually eliminated (0.1% of GDP). The resultant economic relapse, based on efforts to balance the budget, exacerbated by a nonsensically tight monetary policy brought on by the Fed, duly followed.
This is unsurprising. Any type of fiscal austerity during a period of economic slowdown, whether via government spending cuts or higher taxes, will indeed depress economic activity.

But the other lesson of the Great Depression is that properly targeted fiscal policy which focuses on job creation can work. The Great Depression was indeed a disastrous human calamity but FDR’s New Deal (including the high wage policies) attenuated the disaster. There is nothing to the claims that the interventions made things worse, other than when Roosevelt himself capitulated to the tired old forces of financial conservatism and fiscal austerianism, and the economy paid the price. Thankfully, FDR was not ideologically wed to the ideas of fiscal austerity and quickly reversed course. It helped, of course, that his Cabinet was well represented by progressive figures such as Frances Perkins, Henry Wallace, Harold Ickes and Harry Hopkins, who overcame the forces of economic conservatism embodied by FDR’s Treasury Secretary, Henry Morgenthau. We need these kinds of progressive forces in current Administration, especially given the recent resignation of CEA head, Christina Romer. It’s time to let go of the old ideology, which created today’s crisis. Here’s hoping that President Obama, like FDR before him, changes course quickly. America is ready for a new New Deal.

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UPDATE: September 6, 2010 8:20am

See Krugman today as well:

1938 in 2010 [5]

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Marshall Auerback is a Denver, Colorado-based global portfolio strategist for RAB Capital plc and a Fellow with the Economists for Peace and Security [6] (http://www.epsusa.org/). He is a frequent contributor to the blog, Credit Writedowns, and the Japan Policy Research Institute [7] (www.jpri.org) and is a contributor to The Big Picture. Auerback is also a fellow at the Roosevelt Institute [8].

via New Deal 2.0 [9]


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2010/09/the-real-lesson-from-the-great-depression-fiscal-policy-works/

URLs in this post:

[1] Fiscal austerians: http://www.ritholtz.com/blog../2010/06/word-origins-austerians/

[2] argue: http://online.wsj.com/article/SB10001424052748703461504575443402028756986.html?KEYWORDS=THOMAS+F+COOLEY+AND+LEE+E+OHANIAN

[3] here: http://www.whitehouse.gov/omb/budget/Historicals/

[4] here: http://bilbo.economicoutlook.net/blog/?p=7261

[5] 1938 in 2010: http://www.nytimes.com/2010/09/06/opinion/06krugman.html

[6] Economists for Peace and Security: http://www.epsusa.org/

[7] Japan Policy Research Institute: http://www.ritholtz.com/blog../2010/02/2009/02/time-for-a-new-%E2%80%9Cnew-deal%E2%80%9D/www.jpri.org

[8] Roosevelt Institute: http://www.newdeal20.org/?author=48

[9] New Deal 2.0: http://www.ritholtz.com/blog../2010/02/navigating-the-jobs-crisis-time-to-try-government-as-employer-of-last-resort/ND2.0%20%20http://www.newdeal20.org/?p=6349

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